Act now – and beat the taxman
The world of finance can seem like a labyrinth of jargon and confusing terminology. James Daley introduces the things you really need to know
Wednesday 01 April 2009
It's little wonder that the British are among the worst in the world when it comes to understanding and managing their finances. Until very recently, personal finance was rarely taught in schools, and a string of financial mis-selling scandals across the Eighties and Nineties understandably left people wary of trusting insurers or financial advisers when it came to deciding what to do with their money.
Meanwhile, for those who were brave enough to try to work it out themselves, there's been an ever growing alphabet soup of acronyms and other jargon to wade through – ISAs, Oeics, Sipps etc – which is often enough to put people off before they've got going.
But there's nothing like a recession for focusing people's minds on their finances. And with interest rates at all-time lows of just 0.5 per cent, it's become all the more important to ensure that you're getting the most out of your savings and investments.
Furthermore, with just a few days until the end of the tax year, on 5 April, now's the perfect time to learn. Making use of your annual tax allowances can save you thousands of pounds a year.
Individual Savings Accounts (ISAs)
ISAs are a type of account that allow you to earn interest or grow your investments without paying any tax. They were introduced in 1999 to replace Tessas (Tax Exempt Special Savings Accounts) and PEPs (Personal Equity Plans) – and should be the first port of call when you think about opening a savings or investment account.
There are two main types of ISAs: cash ISAs and stocks and shares ISAs. Cash ISAs are simply savings accounts that pay you interest on your savings without deducting any tax. Within a regular bank or building society savings account, for example, 20 per cent tax would automatically be deducted from any interest you earned.
And if you are a higher-rate taxpayer (earning over around £42,000 a year), you'd have to pay another 20 per cent tax when you filed your tax return. Within an ISA, however, all interest is tax-free.
You can put up to £3,600 each year into a cash ISA – and it's possible to transfer money from one cash ISA to another without losing your tax breaks. To find the best cash ISA rates, it's worth having a search around the internet. Comparison websites such as moneyfacts.co.uk and moneysupermarket.com will show you the best deals on the market, and allow you to filter out accounts that don't match your requirements.
Some accounts, for example, will require you to lock up your money for a year or more. In return, these accounts will usually pay you a fixed rate of interest. So at the moment, for example, Leeds Building Society is offering savers an attractive 3.5 per cent annual interest on the condition that they tie up their cash for five years. Although these accounts usually allow you to withdraw your money in an emergency, you'll usually lose all the interest if you don't hold them until the end of the term.
If you need to know that your money is instantly accessible whenever you need it, NatWest is offering a cash ISA paying 3.51 per cent – but this rate could change at any time.
Stocks AND Shares ISAs
Stocks and shares ISAs allow you to invest in the stock market, or in unit trusts or other investment products, without paying any tax on any profits you make. Higher-rate taxpayers also pay less tax on dividends within an ISA.
You can invest up to £7,200 in a stocks and shares ISA each tax year. However, if you've already taken out a cash ISA in the same tax year, you can only invest a maximum of £3,600.
Unless you're a relatively sophisticated investor, the best way to get started with a stocks and shares ISA is to invest in a mutual fund, such as a unit trust, investment trust or Oeic (open-ended investment company).
These are basically portfolios of shares managed by professionals. Your choice of fund will depend on your attitude to risk. But you should be looking to invest for at least five years if you're putting your money into equity funds (those that invest in shares) or bond funds (those that invest in the debt of companies.)
If you're looking for a medium-risk investment, which would be suitable for taking your first steps into the market, you might want to look at a "tracker fund" – such as L&G UK Index. These funds track a stock-market index and don't rely on the judgement of any one individual or team. As a result, they charge lower fees than other mutual funds.
However, the very best fund managers will produce you much better returns than you'll ever get from a tracker fund. Over the past 10 years, for example, the Invesco Perpetual UK Income fund – managed by the highly respected Neil Woodford – has more than doubled investors' money. In contrast, investing in a tracker fund would have lost investors money over the same period.
To invest your ISA allowance into a mutual fund, you can often simply go to the fund management company directly – and follow instructions from their website. However, if you think you may want to broaden your investment portfolio over time, it makes sense to use a "fund supermarket" such as Fidelity's FundsNetwork ( www.fundsnetwork.co.uk ) which will allow you to invest in a range of different products from one account.
If you want to invest directly in stocks and shares – and plan to hold these in your ISA – you'll need to open a stockbroking account. Companies such as TD Waterhouse ( www.tdwaterhouse .co.uk ), the Share Centre ( www.share.com ) and E-trade ( www.etrade.com ) are amongst a number of companies that offer "self-select" ISAs, which allow you to invest directly in shares from your ISA.
If you're nervous about investing a big lump of money all at once, while markets are as volatile as they are, it may make better sense to drip a little into your account each month. This allows you to keep on buying at cheaper levels if markets continue to fall in the short-term.
If you're saving for retirement, the most tax-efficient way to save is within a pension. If you're a basic-rate taxpayer (earning less than around £42,000 a year), you'll get £1 of savings for every 80p you save into a pension. And if you're a higher-rate taxpayer, you'll get an even better deal – just £1 saved for every 60p you put in.
Tax relief isn't the only reason to save into a pension. If your employer offers a company scheme, it'll usually make an additional contribution into your pension on your behalf. If you don't take it up on this, you're effectively throwing away deferred pay. You can save up to 100 per cent of your salary (up to a maximum of £235,000) into a pension each year. However, there's no limit in the last year before you retire, apart from the lifetime limit of £1.65m – which most of us won't be lucky enough to get close to.
Other tax-efficient investments
If you've the appetite for extra risk, there are a number of products that have very attractive tax breaks – some of which can even help you to reduce tax bills you may have already paid. Enterprise Investment Schemes (EISs), for example, are vehicles that invest in a handful of small or start-up companies, and which come with a 20 per cent income-tax kickback if you hold them for a minimum of three years. This means that if you invest £50,000, you'll get £10,000 off your tax bill for the tax year in which you invest (although this will be taken away if you sell your investment within three years).
EISs also allow you to defer capital gains tax (CGT) up to three years in the past or the future. So let's say you bought a second home in France which you sold for a £100,000 profit two years ago. At the time you sold it, you would have been taxed at 40 per cent on most of your gain – which would amount to the best part of £40,000. However, if you invested £40,000 in an EIS this year, you'd be entitled to claim the tax that you claimed back. Better still, the capital gains rate was reduced from 40 to 18 per cent last year – so when you sell the EIS, you'll still have to pay tax on your capital gain, but only at 18 per cent.
EISs are also exempt from inheritance tax after you've held them for two years, which could save your family thousands of pounds in tax when you die. Although they sound like a risky prospect, companies such as Downing now offer EISs which are only moderately risky. They invest in companies that own property or other assets or they go for companies that have steady streams of profits from fixed-term contracts. You can invest up to £500,000 in EISs each tax year.
Venture capital trusts are another tax-efficient investment. These come with a 30 per cent income-tax kickback if you hold them for five years. However, they don't have the capital gains deferral or inheritance tax exemption that EISs' have. These are complicated investments, and you'll need to find a specialist adviser to invest in them. To find an adviser, visit www.unbiased.co.uk .
Independent Partners; request a free guide on NISAs from Hargreaves Lansdown
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